By Marc Lore, President & CEO at Walmart.com. This article was originally published on LinkedIn.
I’m often asked by entrepreneurs what I wish I’d known before I started raising venture capital.
When I first started out, I tried to raise money at the highest valuation I could. Like many, I thought it would minimize dilution and maximize value.
But after raising close to $1 billion in capital over 10 rounds of venture financing, I’ve come to realize that raising money at a high valuation is usually NOT the right decision. It’s short-sighted and risky.
Instead, you’re far better off thinking about raising capital as a series of financing rounds. And when looking through that lens, you’ll see that a high valuation in one round decreases the probability of getting funded in the next one. And it’s those subsequent rounds that are essential for a business to have long-term success and health.
Taking a discount on the valuation will help create positive momentum and scarcity for your stock—both of which dramatically improve your chances of getting funded in subsequent rounds.
While the appropriate discount will vary depending on the circumstances, I recommend taking at least a 15% discount to your pre-money valuation as a rule of thumb. While that might seem high after five rounds of discounting your valuation, it’s the difference between a founder owning 22% of the company versus 18%. The dilution is a small price to pay for dramatically improving your chances of a successful exit.
When you take a discount on your valuation, you’re able to lower your financial projections, and then beat them.
I’ve often put together the most conservative financial plans that venture capitalists would still be willing to invest in. By doing that, I gained the ability to increase my projections along the way and show momentum. Investors love to see founders raise projections, especially since so few ever achieve their plan.
Discounting the valuation has another benefit. It puts investors “in the money” the day after the round is closed, increasing the chances of a nice step up in valuation the following round. The venture community is small, and word will get around if a company is beating its projections and VCs are making money.
Being OK with a lower valuation also makes it much easier to get a deal. Investors won’t tell you this, but the truth is that no one wants to invest in a deal that’s perceived as easy to get into, or is at risk of coming up short on the intended amount. It has nothing to do with anyone’s financial aptitude; it’s just basic human psychology.
Investors love to hear that a round is “oversubscribed”—that’s the magic word. And once you have the initial round size secured, you often can extend the size of the round and raise what you need while keeping the valuation at the same level.
I would often give investors a smaller stake in the company than they ideally wanted so that they would be hungry to invest more in the next round. And nothing gets potential new investors more excited than seeing existing investors eager to invest more than their pro-rata share in subsequent rounds of financing.
If you still aren’t convinced, here are three more reasons to take a discount on your valuation:
- First, you get better investors. I've seen too many cases where second-tier investors outbid the top-tier. But a lower valuation ensures the very best investors want in.
- Second, a lower valuation helps protect you from a down round. Even great businesses face unexpected challenges like market downturns; I raised money during the 2001 and 2008 market corrections, and it was rough. Valuations got slammed, and the end result for many was a down round that seriously hurt their companies’ stature and ability to raise more money.
- The third and probably least understood reason is that a lower valuation allows you more headroom for an exit. I’ve seen many entrepreneurs raise money at valuations that are higher than any buyer would be willing to pay. The result is that they get themselves boxed in, and when they see an opportunity to exit they can’t get a deal investors will agree to because their last round was done at too high of a price.
Most entrepreneurs assume that as long as their business is doing well it will get funded, but that is simply not the case. I’ve seen many good businesses fail to get funded because the investment opportunities were no longer interesting at the current valuation. But I’ve yet to run into anyone with a successful exit who wished they’d pushed for a higher valuation along the way.
Taking a discount on your valuation will help create positive momentum and scarcity, bring in a better class of investors, protect you in rough market conditions, and position you nicely if you choose to exit. A little extra dilution is a small price to pay. Good luck!